Rebasing the EU ETS cap won’t increase uncertainty

Sandbag has proposed rebasing the starting level of the cap under Phase 4 of Europe’s Emissions Trading System (EU ETS) to reflect actual emissions in 2020.This is the most appropriate reform option for addressing the immediate imbalance between supply and demand in the ETS. It has been argued that this will increase uncertainty because the level of emissions in 2020, and therefore the starting point of the cap, is unknown at present.

While it is true that the level of emissions for 2020 is uncertain, aligning the cap with actual emissions actually decreasesuncertainty around the supply-demand balance in the market. Prices of allowances depend on the balance between supply and demand. With a cap fixed in advance and actual emissions uncertain, the supply demand balance is always uncertain. Emissions may be well below the cap, or only a little below the cap, or even (though this is highly unlikely) above the cap. Market participants are therefore uncertain about the net supply demand balance and consequently they are exposed to additional price risks.

In contrast, if the cap is aligned with the reality of emissions at the end of Phase 3 there is much greater confidence that supply and demand will approximately match on an annual basis at the beginning of the phase. There will, of course, still be a large surplus carried over from Phase 3. The uncertainty around the difference between supply and demand at the start of Phase 4 is reduced by an order of magnitude by rebasing. Businesses can make clearer assessments on this basis.

Rebasing the cap increases certainty in other ways as well:

Rebasing helps ensure that actual emissions in Phase 4 are consistent with the targeted reduction of at least 43% by 2030;

Rebasing reduces the size of the MSR, which is likely to grow to levels which create instability due to uncertainty about what might happen to such a large number of allowances (see yesterday’s blog);

Rebasing reduces the likelihood of large changes in future, for example resulting from to reviews under the Paris process.

If there is still concern that the total number of allowances able to be allocated free of charge needs to be fixed in advance of rebasing this can be achieved simply by adjusting the share of free allocation by approximately the same percentage as the cap is rebased. This retains the absolute amount of freely allocated allowances unchanged[1], in effect taking the reduction of the cap entirely from the auction share.

Alternatively, certainty could be created by setting the reference period for rebasing earlier than 2020, with level of the cap rolled forward to 2020 by the LRF, or by a specified amount that reflects the trend of historic emissions. This would give earlier certainty about the cap. However, this is not the preferred approach because rebasing from a period later in Phase 3 allows the cap to more closely reflect reality at the start of Phase 4.

Any requirement to fix the total available allocation to industry, therefore, does not form a valid objection to rebasing.

[1] If the cap is rebased by a percentage p the share of free allocation needs to be increased by approximately 1/p to obtain the same absolute volume of allowances available for free allocation. So if the cap is rebased to 90% of its previous value, with a free allocation share of 43%, the free allocation share needs to be increased to approximately 43%/90% = 48%. However, we note that in practice various other factors such as allocations to funds need to be taken into account to get a precise equivalence.